Less than the Least

Lehman's Demise--Skeel

The government's dance with Lehman after having bailed out Bear Stearns reminded me of a game we used to play as kids. One kid would stand in front of another and fall backwards. The idea was that the kid in back would catch his falling friend. The Fed and Treasury are like the kid in back. Unfortunately, it's now completely unclear whether and when they'll catch an investment bank as it falls.

I don't mean to suggest the government should have bailed Lehman out. I don't think they should have. But they've managed to create a situation where it's almost completely uncertain whether the government will or won't step in. This is one problem.

But there's a second problem as well: the government is focusing too much on the wrong issue.

The underlying issue that complicates everything else is the continuing uncertainty about asset values. No one knows what Lehman's assets are worth, especially the assets related to real estate. This is why Lehman's competitors weren't willing to step in unless the government provided some kind of guaranty. When the government walked, so did they.

One reason for the uncertainty about asset values, I suspect, is the government's failure to do more to address the subprime crisis. Last month's Fannie Mae legislation promises a government guaranty of mortgages that are restructured, but leaves the decision up to the lender whether or not to restructure. Almost no one thinks that enough mortgages will be restructured to make a real dent in the mortgage crisis. It seems clear that a more aggressive approach is needed, such as enactment of the proposed bankruptcy reform that would allow borrowers to write down their mortgages in bankruptcy (as discussed in earlier posts, such as this one).

If there were a serious effort to fix the mortgage mess, and real estate prices reached more of an equilibrium as a result, the government's presence would be a lot less essential when a bank like Lehman ran into trouble. Assets would be easier to value, and a troubled but viable bank might be able to find non-governmental financing, even without the government's help. In the meantime, we're stuck with a world where the Fed and Treasury make case by case decisions whether or not to catch a bank as it falls, and no one steps in if they don't.

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David,

In my textbook on international finance, which was published at the beginning of 1992, I called attention to a fundamental structural problem in the U.S. economy, namely the very low personal saving rate that, in my judgment, had led to a seemingly permanent excess of imports over exports in what economists call the current account. This problem has persisted until the present day. In practical terms, the way it works is that the United States pays for its current account deficit in dollars that foreigners, including governments, use to buy dollar assets. And so we have become the world's great debtor nation.

In order to keep our "creditors" happy, we have to offer returns on their assets that will keep them from dumping dollars. Unfortunately, the Fed's decision to keep pumping money into the economy to keep interest rates low has required those charged with keeping the economic wheels properly lubricated have looked the other way when financial firms have performed the feat of turning inherently illiguid home mortgages into leveraged securities with supposedly high rates of return. And, of course, foreign governments and others snapped up claims on Fannie Mae and Freedy Mac because of the implied federal guarantee.

The Clinton administration pushed for and got legislation that was designed to pressure home lenders to lend to people living in "red lined" areas and who would be high risks by conventional lending standards. Of course, the financial institutions fell all over themselves to play the game according to the rules that were set up, and we were off to the races with the great real estate boom, which, by the way, further undermined personal saving. Why save when you can borrow on your rising home equity?

In any event, it should be a great boom time for those who are specialized in bankruptcy law! I wish those members of Congress who set economic policy would demonstrate some understanding of the underlying factors that produce long-term economic growth. As I used to say in lecture, however, in politics, the long run is the period after the next election, and I fear worst before wisdom finally takes over.

John, this is really helpful. It seems to me that a small, initial illustration of where this could all be heading is the growing reluctance of sovereign wealth funds and other foreign investors to invest in U.S. financial services firms as the financial crisis has increased.

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We are both law professors and evangelical Protestants – a weird
combination in our time. We hope it’s also an interesting combination.
We plan to write about the things that interest us, professionally and
personally: crime and criminal justice (Stuntz), corporate governance,
credit, and bankruptcy (Skeel), the culture wars, politics, literature
and the arts, and other topics.